When do sectors matter, and what can you do about it? Sometimes the sector composition of an equity portfolio strongly affects its returns. At other times, single stock effects or overall market effects dominate.
Sector-based products such as ETFs and futures have been around for decades, but recently they have attracted growing interest. Exhibit 1 illustrates the increase in open interest and volumes in products linked to S&P DJI’s U.S. sector and industry indices since 2013. Both series show a more-than-doubling of investor usage in the past six years.
Exhibit 1: Growing Usage in Products Linked to Sector Indices
This growth might be attributed to a wider trend toward index-based investing in the general market, particularly by financial advisors. However, the growth in trading volume handily exceeds the growth of assets under management, which suggests an alternative user base to the traditional “buy and hold” mentality of passive investors. Active investors might be hedging the sector exposures of their single-stock picks, or they might be making direct bets on the relative fortunes of sectors. In either case, they seem to be doing more of it than they used to do.
Why now? The answer is that the strength of sectoral effects in equities has increased.
We discuss this in depth in our recently published paper, Sector Effects in the S&P 500®, which outlines a method to measure the relative importance of sectors in determining the risks and performance of constituents. The result of this analysis is shown in Exhibit 2. When the series of Exhibit 2 rises, it tells us that a stock’s sector membership is of growing importance, relative to its market (S&P 500) membership. When the series declines, sector effects are less important in driving returns.
Exhibit 2: Sector Importance Has Risen Significantly Since 2013
The rising trend of the series in the past six years offers one explanation for the rising usage of sector-based products, which naturally find greater application when sectoral exposures are more dominant in determining outcomes.
The relative importance of sectors has important applications for effective active management in single stocks, as well as offering a perspective on the extent to which “macro” concerns are driving returns. For a useful in-depth understanding these sectoral trends, have a read of the paper. Or to simply monitor the ongoing dynamics of Exhibit 2, follow our monthly sector dashboards for updates.